Basics of Investing in Stocks: What is a Stock?

Key Takeaways

A stock represents partial ownership of a company, and thus a claim on future earnings

Companies may retain earnings, or pay out a portion to shareholders as dividends

A stock’s value is the present value of future earnings, but determining present value involves many considerations [A stock’s value is the present value of future earnings, but determining present value involves many considerations]

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See if this scenario sounds familiar. You’ve decided it’s time to learn the basics of investing, and you want to learn how to start investing in the stock market. So you flip over to a business news channel, or turn to a market publication, and suddenly you’re bombarded with information about earnings and revenue and dividends and other foreign-sounding terms.

So you shout at the screen, “Hang on. What is a stock, anyway?” Let’s dial it back a notch.

What is a stock, or a dividend? How do I invest in the stock market? How is stock value determined, and why do stock prices fluctuate?

In the long investment journey to a goal, perhaps retirement, we all have to start somewhere. So here are the first strides along the path.

What Is a Stock?

Investing in a stock means partial ownership of a corporation. The exact amount depends on the corporation’s size and the total number of stock shares issued. So if you own 100 shares, and the company has issued 10,000 shares, you own 1% of the company. Of course, these days a large corporation for example, Microsoft (MSFT), has 8 billion shares outstanding, which means 100 shares are, as a percentage of the company, a really, really small number.

But hey, at least you’re in the game.

Earnings and Dividends

So, for this example, owning 100 shares of MSFT puts you in the company of Bill Gates (technically), and each share comes with the ability to vote on some company matters, your vote won’t hold the same sway as that of a large shareholder like Mr. Gates. But your shares do represent a tangible ownership of the company’s assets, and a claim on its future earnings. That’s the amount of profit, or loss, that a company produces during a specific period, such as quarterly or annually.

Frequently, earnings are reported on a per-share basis, in what’s called—you guessed it—earnings per share (EPS). If a company makes $2 billion in earnings in a quarter, and there are a billion shares outstanding, the EPS is $2 for the quarter.

In this scenario, the company has two choices as to what to do with that $2 billion. It could keep it in-house to fund operations, new projects, or perhaps a “war chest” for future initiatives. This is called retained earnings. Or, it could deliver a portion of the earnings to shareholders in what’s called a dividend.

So if a company decides to declare a dividend of $0.50 per share in a given quarter, then your 100 shares could entitle you to $50 in dividends. Some companies pay regular dividends (though future dividends aren’t guaranteed), and some companies, such as younger or fast-growing companies, choose to retain all earnings. Of course, earnings aren’t a guarantee; some companies generate losses.

Earnings and the Value of a Stock

If you’re interested in investing in stocks, you’ll likely want to know what constitutes a good entry price, or, in other words, whether a stock is a good value. Stock valuation (and there are many people on Wall Street and beyond whose job is exactly that), the EPS number matters. Stock prices are essentially windows into the future. They represent what investors think future EPS numbers will be. And the higher those expectations are, the higher the current price.

It sounds easy, but really, there’s a lot of complicated math that goes into the calculation of stock prices and their relationships to EPS. One important concept is the time value of money. Let’s break that down.

There’s a character from the old Popeye comics named Wimpy, whose tagline was “I will gladly pay you Tuesday for a hamburger today!” Why is that important? Because a hamburger (or a dollar, or any asset) today can be more valuable than having a claim on an asset to be delivered tomorrow, or Tuesday, or any date in the future. So the future earnings of a company need to be translated into a present value. How much should you pay for a dollar tomorrow, or a dollar next year? Since future earnings can be worth less in today’s dollars, the stock price should be a function of when the expected earnings occur in the future. The further in the future a dollar of earnings is, the lower its present value. This process is called discounting, and it’s an important concept to grasp for those wishing to learn how to invest in stocks.

Volatility

Discounting is a math-heavy process, but its basic idea is the old proverb “a bird in the hand is worth two in the bush.” Of course, we don’t know how many birds there are in the bush until we see them, and we don’t know what a company might earn or lose in the future until we get there. So between today and the hazy future, stock prices will fluctuate as things happen and investors and analysts make changes to their earnings estimates.

Sometimes earnings, and earnings growth, are somewhat predictable, and stock prices don’t fluctuate much. At other times, there is much uncertainty, and stock prices fluctuate a lot. This is called volatility. When you start investing in stocks, and begin following the market, you’ll likely encounter periods of volatility

Changes in interest rates, trade policies, economic trends, war—these are just a few of the things that can affect future earnings of the market, and thus, market volatility. And for an individual stock, there are even more things to consider—the competitive environment, potential future performance, potential mergers and acquisitions, and more.

Investing in stocks can be a tricky business that involves risk, but it can also be rewarding, and can pay dividends in the most literal sense. A good first step is understanding the basics.

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